Woolworths dip food for thought

The first profit downgrade by retailer
Woolworths
in at least 20 years is bound to make its 400,000 loyal retail investors more than a little nervous and lead to questions about whether the company is being hit by cyclical factors or specific problems that management and the board need to address.

If Woolies is being hit by industry-wide issues, it should become clear from the market announcements by other companies in the sector over the next few weeks, including the ­second-quarter sales figures being released on Monday by its arch rival, Coles, which is owned by
­Wesfarmers
.

If the problems are company-specific, the spotlight will shine brightly on chairman
James Strong
and chief executive
Michael Luscombe
, who find themselves in the unusual situation of defending the evaporation of the premium that was once paid for Woolworths shares.

Woolworths has been a market darling for more than a decade. It was, and still is, included in portfolios of fund managers, retail investors and self-managed super funds without hesitation and without much risk of questions being asked.

But after yesterday’s profit downgrade that compulsory purchase ­status will be less easily accepted by investors.

The company’s shares traditionally traded at a 15 per cent premium to the ASX S&P 200 Index because successive CEOs – Reg Clairs, Roger Corbett and Luscombe – delivered consistent double-digit earnings growth. It is a tribute to the Woolworths management and board that the company managed to get through the ­global financial crisis without having to make a dilutive share issue.

It emerged from the GFC with a balance sheet strong enough to embark on a $700 million capital management program at a time when most companies were still battening down the hatches. A big factor in the consistent long-term earnings growth was a company-wide commitment to cost cutting, including the $1 billion Project Refresh logistics streamlining program. Luscombe has embarked on a $1 billion cost cutting exercise called Project Quantum, more details of which will be released with the half-year financial results on February 25.

Several analysts had expected the early benefits of Project Quantum to offset the bunch of negative factors hitting Woolworths and allow the company to meet the guidance it reaffirmed in November for net profit growth of between 8 and 11 per cent for the year to June 2011.

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That guidance was issued despite poor performances in October and November by the company’s discretionary retail businesses – Big W and Dick Smith Electronics. Management had factored in a very strong December sales period but that did not eventuate.

Australians held back spending in December in anticipation of cheaper goods in the post-Christmas sales.

That frugal consumer behaviour must have affected the sales of the discretionary retail arms of Coles, Kmart and Target, being released on Monday.

Luscombe says the downgrade in the Woolworths net profit growth to a range of 5 to 8 per cent should be viewed as the company not meeting its own expectations because of ­factors outside its control.

Woolworths managers must present rolling five-year plans for sales and earnings. The board relies on these forecasts to present earnings guidance.

There are no plans to change this approach even though the easy option adopted by most listed companies is to give no guidance and update earnings only if they are out of whack with consensus estimates, which gives room for wriggling out of continuous disclosure.

Factors outside the control of ­Luscombe and his team are the increased savings by Australians worried about the state of the world, the higher Australian dollar; the increase in interest rates; the unseasonably poor weather; deflation in food and liquor and significant deflation in key general merchandise.

However, there are things it controls that may have contributed to the earnings downgrade and the loss of a growth premium.

It has promotional campaigns in food and liquor to boost sales. This strategy has not worked, according to Merrill Lynch analyst David ­Errington, who says the higher sales have not delivered higher margins. Errington’s December downgrade of the stock, including a 12-month price target of $24.50, was prescient.

He says Woolworths has lost sales momentum to Coles and widened its profit margins too much to the detriment of longer-term growth. The widening gap between the performance of Woolworths and Coles is expected to show through on Monday.

Coles is expected to deliver second-quarter growth in food and ­liquor comparative sales of about 7 per cent compared with 2.5 per cent for Woolworths. In the first half, Woolworths’ comparative food and liquor sales were down 3.8 per cent.

One factor that was in control of the company was its insurance arrangements. It had insurance protection for the Queensland floods and the earthquake in New Zealand but under its policies, the excess arrangements mean it will have ­unrecoverable costs that will affect its net profit.

Another criticism directed at Woolworths has been its frequent-flyer deal with
Qantas
. But the company dismisses the claim by Errington that it is costing $100 million a year without delivering much benefit to the bottom line.

The loss of Woolworths’ market darling status comes at a time when institutional investors are asking if Strong and Luscombe will have a conversation this year about succession planning.

It is a tricky issue for any board to manage because it can trigger tension in management ranks and distract attention from the job at hand. It is especially tricky for Woolworths given its track record on succession.

Luscombe will this year celebrate five years as CEO and 34 years in retail, which is a seven-day-a-week job. His predecessor, Corbett, was in the job for six years. Corbett actually gave the board two years’ notice to prepare for his departure but was forced to stay on for two years while a replacement was found.

The most obvious internal replacement for Luscombe is the head of supermarkets, liquor and petrol,
Greg Foran
. Foran came to Woolworths after working for Warehouse Group in New Zealand. He worked in the UK for the Dairy Farm group. He is responsible for the successful Big W repositioning strategy.

It would be understandable if there was anxiety at the Woolworths board level about the succession options given the rapidly evolving retail environment in Australia, including the disruptive impact of the internet.

It is possible that the negative factors that forced yesterday’s downgrade are part of a fundamental systemic change in the discretionary retail market in Australia. If that is the case, it will put extraordinary pressure on the company and whoever is running it in 2012.